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Debt Financing

Short-Term Debt Financing

What is it?

As is obvious in the name, short term debt financing is a form of financing involving financial obligations that must be fulfilled usually within a year to two at most. It is more often used for working capital requirements, or day-to-day operations of the business. By the same token, businesses with cyclical operating conditions (for e.g. retailers) or those engaged in international trade will usually obtain financing through short-term debt. There are 4 main types of short-term debt financing options:

  • Overdraft
  • Overdraft is an instant extension of credit from a lending institution. When a company has an overdraft arrangement with a bank, it can draw down or transmit cash from its account beyond the available balance. It is also revolving in nature; does not have a fixed repayment period. The amount of credit will depend on the overdraft limit negotiated with the bank. (The advantage of an overdraft arrangement is that the company does not have to ensure that sufficient cash is always available for operating activities such as stock turnover or payment to creditors in the short term).

  • Letter of Credit
  • Letter of Credit is a letter from a bank guaranteeing a buyer's payment to a seller, that a seller will receive the amount within the credit period. The advantage of having such an arrangement with a bank is that it enables a company to negotiate better credit terms (E.g. longer credit period) with suppliers.

  • Short-Term Loan
  • Short-term loan is, as the name suggests, a loan that must be repaid within a year or less, with interest. It is not revolving in nature; has a fixed repayment period. Companies will usually find this form of debt financing useful if liquidity is a concern, in particular short-term working capital requirements (For e.g., to purchase stocks or to pay creditors).

  • Bill of Exchange
  • Bill of Exchange is a document that binds one party to pay a fixed sum of money to another party at a specified future date. It is often used in international trade. An exporter can grant credit to an importer for goods shipped, by drawing a Bill of Exchange to the same amount and credit period.

Who qualifies for it?

Basically, there are no formal qualifying criteria for obtaining short term debt financing. In general, companies need to have owner's capital and a strong business case to support the viability of the business. Suppliers offer short term credit on purchases to enhance their competitiveness; banks offer short term loans and overdrafts to earn interest as well as to build on client relationships. Hence, as long as the company is relatively transparent in its financials and operations, and is not 'blacklisted' on the credit bureau, or has a bad reputation in the industry for defaulting on debts, short term debt financing is possible.

What are the advantages and disadvantages?

Short term debt financing provides the business with liquidity to conduct its day-to-day operations and to maintain working capital needs. However, they do present some disadvantages to the business as well. These are detailed below.

Short Term Debt
Advantages Disadvantages
  • Source of 'quick' liquidity
  • Help tide over short term shocks
  • Relatively easy to negotiate
  • Free up funds for investment opportunities in the short term
  • Less need for collaterals and pledges
  • Relatively low cost of servicing
  • Time and resources for monitoring and maintaining short-term credit
  • Not useful for long term capital needs
  • Short term debt financing is a source of 'quick' liquidity for the business, in particular SMEs, who do not have large pool of reserve funds for emergency uses.
  • Small enterprises are more prone to short term shocks from their operating environment such as a large debtor declaring bankrupt, or an abruptly ceased partnership with a major supplier. Hence, short term debt financing provides almost immediate funds to tide over such difficult situations that could otherwise impact the going concern of SMEs.
  • Short term debt financing is usually easier to negotiate (compared to long term debts and equity financing), as the financier faces relatively lower credit risk.
  • Due to the ease of negotiation, short term debt financing can be used to free up funds in the business for good investment opportunities that would otherwise have been foregone.
  • Most short term debt financing instruments can be obtained without having to pledge a considerable amount of collateral, as long as the borrowing company has relatively stable operations and turnover rate (i.e. moderate business risk).
  • The cost of servicing short-term credit is less taxing on the company. Short-term loans usually offer lower interest charges, and most suppliers do not charge interest at all until the credit allowance period is breached.
  • Short term debt financing has to be monitored closely to avoid bad relationships with suppliers and bankers, or a bad reputation in the industry for not paying debts on time.
  • Short-term debts only meet working capital or immediate business needs. They are not useful for servicing any long term plans with larger capital requirements, higher risk, and longer payback horizons.

What are the risks?

The following are some of the risks that come with short term debt financing.

  • Over-reliance on certain lines of short-term credit, especially from suppliers, may cause the company to take on more business risk in offering aggressive credit terms to customers. In the event that the suppliers change their credit terms, the company will be put in a position of payable-receivable mismatch (i.e. paying faster than collections). Changing its own credit terms may mean loss of customers and market share.
  • Badly maintained credit lines (late payments etc) may result in the company being 'blacklisted' by credit bureaus or industry players, making it more difficult or expensive to obtain financing in future.

Long-Term Debt Financing

What is it?

In contrast to short-term borrowings, long-term debt is used to finance business investments that have longer payback periods. For example, the purchases of machinery, which may help the company, produce goods over a 5-year period. There are 2 main types of long term debt financing options:

  • Term Loan
  • Basically, term loan is a loan with a repayment period of more than one year. It is usually taken by companies with longer investment or payback horizons, such as building of a new factory or purchase of new production equipment. A bank term loan is usually repaid via periodic instalments.

    • Mortgage is basically a long-term loan, secured by a collateral of some specified real estate property. The loan is normally amortised and the borrower is obligated to make a periodic instalments to repay the loan. Failing which, the lender can enforce its rights to possess the mortgaged property.
  • Leasing
  • Leasing, in general, allows a company use of an asset without having to pay the full amount upfront. A leasing agreement is drawn up with the lessee agreeing to pay periodic rental payments in exchange for the use of a capital asset. It is in effect a rental agreement, apart from a clause, which allows the lessee to own, or to buy over the machine at a reduced rate, at the end of the lease agreement.

Who qualifies for it?

Long term debt financing is usually more risky to the financier as it involves longer payback periods and thus higher credit risks. Hence, long-term debt financiers would usually require the borrowing company to pledge some form of asset as collateral. Such assets can range from inventories to factories and properties. The amount of funds that the company is able to obtain through long term debt financing would depend greatly on the value of assets, which the company is able and willing to pledge.

Generally, long term debt financiers will also look at the credit worthiness of the borrowing company, in terms of its long term business prospects, cash flows, profitability, capital structure (debt-equity ratio) and other qualitative factors such as the transparency of operations, credibility and integrity of management etc. Long-term debt financiers such as financial institutions would usually require a set of up-to-date audited financial statements to perform their credit evaluation. Table below shows some of the quantitative factors that are commonly used by long-term debt financiers to evaluate borrowers.

Profitability Profitable companies will find it easier to obtain long term debt financing Profit margins, ROI, ROA
Prospects Businesses that have growing sales turnover show good business viability and prospects Sales growth, profit growth
Cash Flows Companies with more cash flows from operations will find it easier to obtain long term debt financing Cash flows from Operations (cash flow statements)
Solvency Companies that have better solvency ratios are less risky, and thus will find it easier to negotiate credit terms for long term financing Debt-asset ratios, operating leverage, interest coverage ratio
Capital Structure Companies with lower debt to equity mix are less risky, and thus will find it easier to obtain long term debt financing Debt-Equity ratio

What are the advantages and disadvantages?

Like short-term debt financing, long-term borrowings offer advantages as well as disadvantages. These are detailed below and summarized below.

Long Term Debt
  • More stable than short term debt
  • Linked to growth of company's operating capacity
  • Less need for maintenance and monitoring
  • Sources such as leases offer flexibility compared to buying the asset
  • Costly interest charges
  • Need to prepare information for financiers
  • Companies with no track records, cash and asset base will find it more difficult to obtain financing
  • Restrictive clauses and covenants
  • Long term debt financing is usually less prone to short term shocks as it is secured by formally established contractual terms. Hence, they are relatively more stable than short-term debt.
  • Long term debt financing is directly linked to the growth of the company's operating capacity (purchase of capital assets such as machinery).
  • Long-term debt is normally well structured and defined. Thus fewer resources have to be channeled to monitor and maintain long-term debt financing accounts (compared to short term debt financing such as supplier credit which, changes overtime and need to be monitored on a regular basis).
  • Long-term debt financing options such as leases offer a certain degree of flexibility, compared to having to purchase the asset (E.g. machinery).
  • Long term debt is often costly to service (interest charges are higher).
  • Long term debt financiers usually demand a great amount of information from the company to perform its credit evaluation.
  • Start-ups usually find it more difficult to obtain long term debt financing, or if they do, at unfavorable terms, as they have almost no proven track record, low cash flow, and small asset base.
  • Long-term debt financing contracts normally contain a lot of restrictive clauses and covenants, including the scope of business operations that the company is allowed to engage in, capital and management structure limitations, etc.

What are the risks?

Considering the often large amounts of funds involved, long term debt financing is a relatively risky source of financing.

  • Breach of debt covenants may result in the company going into financial distress. For example, certain clauses state that if a certain covenant is breached, the entire loan amount has to be repaid in full immediately, or the mortgaged asset confiscated.
  • Secured creditors may take actions against the company if it is not able to meet payments.
  • If the interest charge is based on a floating rate, interest rates may move adversely against the company, causing huge unplanned and un-hedged increases in interest expenses and cash outflows.